ISTANBUL, May 29 (Reuters) - When Turkish Prime MinisterTayyip Erdogan came to power a decade ago it would have beenalmost unthinkable for his government to issue an Islamic bond,given accusations it was seeking to erode Turkey's secularstatus.

Now, as it seeks to boost political and commercial ties withthe Gulf and diversify its borrowing, one of the Muslim world'smost dynamic economies is developing an Islamic finance industrywhich could rival current volumes in Malaysia - the world's topsukuk issuer - within 10 years.

Turkey has a strong secular identity. Its Islamic banks areknown locally as participation banks, in part reflecting publicsensitivities. But nervousness about Islamic finance has easedin recent years, helped by growth of the sector in Westerneconomies.

Just over a year after its debut dollar-denominated sukukissue, Turkey's Capital Markets Board is finalising regulationson five new types of Islamic bond as the country aims to becomea major issuer of Islamic debt.

The new rules, which were sent to Erdogan's office forapproval this week, will allow Turkish corporates and banks, aswell as the Treasury, to issue the world's most widely usedtypes of sukuk, giving them access to a wider pool of investorsvia a global market estimated at more than $100 billion.

"Islamic finance is just like halal food, there may be tworeasons to choose it," said Mustafa Cetin, head of financialinstitutions at the Turkish arm of Bahrain-based Islamic lenderAl Baraka.

"Either you prefer interest-free products or you find thecost of borrowing, the taste, attractive."

Unlike the oil-fuelled economies of the Gulf, whose Islamicdebt issuance is primarily sovereign, Turkey has a powerfulprivate sector which is increasingly eager to financeinternational projects using sharia-compliant products.

As part of plans to celebrate the 100th anniversary of thefounding of the modern republic in 2023, Turkey aims to turn itseconomic and cultural capital Istanbul into a major financialcentre. It foresees $350 billion of infrastructure spending onthe project, with Islamic finance expected to be one of themajor sources.

Construction company Agaoglu, which will build the IstanbulFinance Center, has said it plans to borrow $2 billion throughsharia-compliant instruments, topping the total value ofTurkey's existing sovereign dollar sukuk issuance.

INDUSTRY SET TO TRIPLE

Turkey's Islamic lenders have enjoyed rapid growth in recentyears but remain a small part of the banking system.

The share of participation banks has risen to 6 percent oftotal banking assets from 2 percent a decade ago, when Erdogan'sJustice and Development (AK) Party first came to power.

As part of efforts to develop the sector, the governmentwants to see that share increase to 15 percent over the nextdecade and is determined to support this through regulation, aswell as by encouraging unbanked rural residents to open accountswith Islamic lenders.

"Turkey's 2023 financial services vision could see theIslamic banking industry tripling in size to more than $100billion, approximately where Malaysia is today," accounting firmErnst & Young said in its latest World Islamic Bank report.

Turkey's two largest state-run banks, Ziraat and Halkbank, look set to help achieve that target, with bothabout to establish their own participation banks.

Turkey's Islamic banking sector may be small given thecountry's population of 76 million is 99 percent Muslim, but itsconventional capital markets are much more developed than manyother Muslim nations.

"Albaraka Turk is growing 20 percent yearly in assets andbranches. That means we are doubling in size every 4-5 years."

The bank will be one of eight primary dealers for a debutsukuk issue, set for June, by the Malaysia-based InternationalIslamic Liquidity Management Corp (IILM), formed to boost globalliquidity in Islamic instruments. Turkey's support for the IILMis seen as further evidence of its commitment to the sector.

Turkey's new regulations, which will allow the use of moreinstruments including Istisna, Murabaha, Mudaraba, Musharaka andWakala bonds, and stronger local Islamic banks should help thecountry attract more funding from the Gulf, where appetite forIslamic products far outstrips supply.

Kuveyt Turk, a subsidiary of Kuwait Finance House,was the first Turkish company to issue a sukuk when it borrowed$100 million in 2010. It then tapped the market in 2011 for a$350 million sharia-compliant issue.